The 5 Little-Known Tax Benefits of Real Estate Investing

Real estate is a solid investment if your goal is to build long-term wealth. The unique combination of passive income and capital appreciation gives real estate an edge like no other asset class. In addition to passive income and appreciation, another often overlooked aspect is the potential tax benefits. These tax incentives can help improve the return on your investment, preserve your wealth, and reduce your overall tax burden. This article will discuss the top 5 little-known tax benefits of real estate investing, including depreciation deductions, W-2 offsets, and 1031 exchanges.

1. One of the Best Tax Benefits of Real Estate Investing: Depreciation Deductions

The ability to deduct depreciation is one of the best benefits of real estate investing, and it’s also one that many people don’t fully understand.

Real estate investors can recover the cost of their investment properties over time through yearly deductions. The IRS allows investors to depreciate residential properties over 27.5 years, while commercial properties can have their depreciation spread out over 39 years. These deductions offset rental income, reducing an investor’s taxable income and liability.

Depreciation is only on the value of the building, however, so you cannot depreciate the value of the land. Still, it’s a significant benefit that enables investors to write off a decent amount of their rental income. And syndications can also take advantage of these depreciation deductions to help reduce the company’s overall tax liability.

2. W-2 Offsets

Individual investors that qualify as real estate professionals under IRS guidelines can offset their W-2 income with losses from their rental properties (read more about Offsetting W2s with K1 Losses). This benefit allows real estate professionals to offset taxable income from other sources, reducing their overall tax burden.

And, sometimes, your only loss is on paper. For example, suppose you could depreciate your property by $10,000 annually. If you made $5,000 on the property before depreciation, your net income would be -$5,000 after depreciation, which would offset your W-2 income by $5,000. Yet, regarding cash flow, you’d be up $5,000 on the rental (tax-free since depreciation covers it) and save taxes on $5,000 of your W-2 income.

To qualify as a real estate professional, investors must meet specific IRS criteria, including a minimum number of hours spent managing their investments each year. Passive investors, unfortunately, do not get this benefit, but if you actively manage many multifamily properties, for example, you’d easily qualify as a professional and get access to this deduction.

3. 1031 Exchanges

Section 1031 of the Internal Revenue Code is one of the littlest-known tax benefits because it is more difficult to execute. It allows real estate investors to defer paying capital gains taxes on the sale of investment properties by reinvesting the proceeds into a new, like-kind property. This tax benefit is known as a 1031 Exchange and enables investors to preserve their wealth, avoid immediate capital gains taxes, and continue to build equity in their investments.

As a simple example, suppose you have a condo that is worth $300,000. You own the condo outright, and it’s making good money, but you see a fabulous new home worth $500,000 you want to buy as your new investment property. Further, suppose the house has a higher income potential.

Usually, you’d have to sell your condo, pay capital gains tax on the sale, and then use the post-tax gains to buy the home. With a 1031 exchange, though, because you are exchanging “like-kind” property, you can defer the capital gains tax and use the entire $300,000 as a down payment on your property.

Of course, if you were to sell the house, you’d pay the capital gains tax on the total amount as you deferred it. But, it’s a great way to defer paying tax and let your equity grow – and it’s one of the better tax benefits of real estate.

4. Mortgage Interest Deductions for Investment Real Estate

For real estate investors, the IRS allows investors to deduct interest on loans used to acquire or improve the property, reducing taxable income. This deduction can save investors significant taxes and make leveraging commercial property investments more attractive. It’s important to note that there may be limitations on the deductibility of mortgage interest, depending on the type of commercial property and the loan structure.

5. Tax Credits and Incentives for Commercial Real Estate

Commercial real estate investors may also be eligible for various tax credits and incentives depending on the property type and location. Some common examples include:

  • Historic Rehabilitation Tax Credit: This federal tax credit is available to investors who rehabilitate certified historic buildings and meet specific criteria. It provides a 20% tax credit on eligible rehabilitation expenses.
  • Energy Efficiency Tax Credits: Investors who implement energy-efficient upgrades to their commercial properties may be eligible for tax credits, such as the Energy Efficient Commercial Building Tax Deduction or the Renewable Energy Tax Credit.
  • Opportunity Zones: Investing in commercial properties within designated Opportunity Zones allows investors to defer or reduce capital gains taxes by reinvesting the proceeds into Qualified Opportunity Funds.

Of course, other unique tax credits and incentives are available for investors. They are often region-specific, so check with your state and local government to see if any special investment tax breaks exist for the property you’re looking to acquire.

These Little-Known Tax Benefits Can Save You Significant Money

These top 5 little-known tax benefits of real estate investing can help investors maximize their returns, reduce tax liability, and preserve their wealth. By understanding and taking advantage of these tax incentives, investors can improve the financial performance of their real estate portfolio and make informed decisions about their investments.

Of course, consulting with a tax professional is essential to ensure that you use these tax benefits in a manner that complies with IRS regulations. For many investments, there could be hundreds of thousands or even millions at stake, and a wrong calculation could result in a significant underpayment or overpayment of your tax liability. Therefore, if you’re looking to take advantage of any of these tax benefits of real estate, please consult with a tax professional.

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